City bets on rates rise

Investors are gambling that rates will have to increase from the current level of five per cent to bring runaway inflation under control. Most had previously expected rates to fall to about 4.5 per cent by the end of the year.

Today's money market interest rates in the City suggest that investors now fear that at least two, and possibly even three, quarter-point base rate increases are on the cards. The money market rates surged at their fastest pace since Black Wednesday in 1992 yesterday after disastrous figures on the soaring price of goods leaving factories.

Although the market is acting on a hunch rather than detailed analysis, economists now fear that this gamble on the worst case scenario "may well" turn out to be right.

Jonathan Loynes, chief European economist at fore-caster Capital Economics, said a rise in rates would make a full-blown recession much more likely.

He said: "The markets may well be right in expecting the next move in interest rates to be up. But they have not yet grasped the likely consequences of this for the economy."

City economists said that at the very best all hopes of an interest rate cut this year have now been snuffed out.

The Bank has cut rates three times since December as the credit crunch has taken hold. However, it has been stopped in its tracks by the price of oil reaching $140 a barrel.

The frightening spectre of a U-turn from the Bank of England came as new figures showed that about 3,000 London home owners are already suffering negative equity.

It is Britain's first large-scale outbreak of negative equity - meaning homes are worth less than the loans they were bought with - since the great property crash of the early Nineties.

Other statistics out today, from the Royal Institution of Chartered Surveyors, show there are fewer transactions per estate agent than at any time in the past 30 years. The negative equity warning comes from the Council of Mortgage Lenders, which says 23,200 homeowners across Britain bought flats or houses with no deposits in the year to the end of March.

Of these, about 3,000 would have been in London. Most of these properties are likely to have fallen in value since the purchases were completed. Banks such as Northern Rock were happy to lend 100 per cent or even 110 per cent during the property boom because they were convinced property prices would go on rising.

However, since the credit crunch began last autumn - of which Northern Rock was the biggest victim - property prices have been on the slide.

The Nineties negative equity crisis coincided with a recession and a huge rise in unemployment that left hundreds of thousands of borrowers saddled with home loans they could not pay back. This time the effect is likely to be less severe as unemployment is still low and the economy is forecast to avoid recession. Also, the length of the 15-year boom means most of Britain's 10.8 million mortgage holders hold healthy chunks of equity.

Negative equity only becomes a major problem when a home owner is forced to sell and cannot pay back the mortgage.

All the major lenders have now called a halt to 100 per cent mortgages and most require deposits of at least 10 per cent.

There was also a warning from a leading City economist that worse is to come. Michael Saunders, chief economist at Citigroup, said: "House prices are down six per cent in the last five months, and the worst of the credit crisis - all that still lies ahead."

He previously predicted that house prices would fall by 15 per cent in 2008 and 2009 but now says the drop could be even greater.